Washington pushes the time envelope on forward delivery bonds
After the 2017 federal tax bill eliminated the use of tax-exempt debt in advance bond refundings, issuers have been forced to rethink their approach to bond refinancings.
The low interest rate environment has made issuing taxable bonds a popular choice for advance refinancing tax exempt debt that hasn't reached its call date. With taxable rates lower than the tax-exempts being refunded, issuers still save money.
That trend is expected to continue in 2020 with gross taxable municipal bond issuance growing to $95 billion, and $63 billion of that refundings, up 132% versus the five-year trailing average, Vikram Rai, head of municipal strategy for Citi, said at his firm's 2020 Municipal Market Outlook Conference in December.
But Washington State Treasurer Duane Davidson took a different tack, using a forward delivery method to achieve refunding savings when he priced $396.3 million in motor vehicle fuel tax general obligation refunding bonds in November.
Tax-exempt forward delivery bonds are priced in the current market, but not issued until a date in the future.
Bookrunner BofA Securities refunded $458.9 million of debt that was originally issued in 2011 to finance a portion of the state’s SR 520 floating bridge project.
Prior to making the decision to employ the method, the treasurer’s office compared the pricing on such a deal versus selling the bonds as taxables, said Jason Richter, Washington State's deputy treasurer of debt management.
“Both produced similar results in terms of savings,” Richter said. “But if we did a taxable advance refunding, the coupon structure and par structure would have made it less likely that we would have been able to refund the debt in the future, even if we embedded a call option in the deal.”
The treasurer’s office said it locked in net present value savings of $76.4 million, or 16.65%. This equates to more than $5 million of annual cash-flow savings for the SR 520 system from fiscal year 2022 through fiscal year 2041, according to the treasurer’s office.
Forward delivery bonds have typically been delivered from three to six months after the bond closing, but the Washington finance team pushed the envelope, scheduling delivery for 16 months out from pricing.
“No funds will be delivered until 2021,” Richter said. “That allows us to lock in rates until 2019 and deliver proceeds in 2021, so that we comply with the IRS regulations of current refundings that funds are delivered within 90 days of the call date.”
Since no money changes hands until the March 3, 2021, delivery date, the state will continue to make principal and interest payments through 2020 and up to the delivery date, Richter said.
Montague DeRose and Associates and Piper Jaffray were financial advisors on the Washington deal. Bond counsel was Foster Garvey P.C.
Some $2.8 billion in par was issued in 2019 using a forward delivery method; that is nearly half of the $5.8 billion in par issued using that method since 2015, according to Refinitiv data.
Washington’s forward delivery could be the furthest out that one has been done, said David Erdman, director of the Wisconsin Capital Finance Office.
Wisconsin has employed the financial tool several times, even before the tax bill passed in 2017, he said. Prior to the tax bill’s passage in 2017, the state used the method on debt that had already been advance refunded, because federal law at the time only allowed one tax-exempt refunding on the same issuance.
“We did one in 2013-14, and then more recently in 2018,” Erdman said.
The guideline for Erdman’s finance team is that if the refinancing call is out six or seven months it works, but if the call date is out two or three years then it has to be taxable, he said.
There is a premium to forward deliveries measured in basis points per month up to the bond delivery, he said. But he believes increased use of the tool since the tax bill passed may have reduced that premium.
“Compared to bonds with a standard (up to 30 days) delivery time period, forward delivery bonds are priced with a yield premium to compensate investors for the illiquidity of their investment during the forward period and for committing funds to be used to purchase the bonds on the future delivery date,” according to the April 2019 issue of Jefferies Insights, the bank's periodic market report. "Given current market conditions with low rates and a flat yield curve, the yield premiums for forward delivery bonds are modest, in the range of 3-6 basis points per month."
Documentation for forward delivery transactions follows standard market formats, including an initial official statement for pricing and an updated official statement when the bonds are issued, according to the Jefferies report.
Washington’s offering documents outlined the risks for investors. The further out that delivery is extended, the longer the bonds are illiquid.
“The underwriters are not obligated to make a secondary market in the bonds, and no assurances can be given that a secondary market will exist for the bonds during the delayed delivery period,” according to the bond documents. “Purchasers of the bonds should assume that the bonds will be illiquid throughout the delayed delivery period. Should events occur before the bonds are issued and delivered by the state on the settlement date that affect the market value of the bonds, and if a secondary market in the bonds does not exist, a beneficial owner of the bonds may be unable to re-sell all or a portion of the bonds held on or behalf of that beneficial owner.”
Jefferies was bookrunner when San Francisco International Airport sold $115 million of Series A refunding bonds that were delivered in February 2018.
“The idea behind the forward delivery was to lock in then-current low interest rates in order to achieve savings,” said Ronda Chu, SFO’s capital finance director. “By issuing a forward delivery, the airport was able to pay a slightly higher interest rate, but remove several months of interest rate risk between the time of pricing and closing date.”
The congressional discussions around tax reform at the time caused quite a consternation in the financial markets, Chu said.
The 2018 bonds closed successfully, she said.
SFO paid a premium of 5 basis points a month on the forward delivery, Chu said.
The airport hasn’t executed any other forward deliveries, because it is in the market at least once a year, so it has been executing current refundings with new money sales, she said.
“We saw a large number of taxable refundings in the last quarter of 2019,” Chu said. “Much of this was driven by very low taxable rates, and compression between taxable and tax-exempt rates. If recent conditions hold, then we may see more taxable advance refundings. However, the market is dynamic. Issuers, like the San Francisco Airport Commission, are likely to continue to assess the overall benefits of each option and their financing needs.”
Matt Fabian, a partner at Municipal Market Analytics, said he used to view forward delivery bonds with a jaundiced eye. But he has changed his mind about forward deliveries, and a number of his clients have purchased the bonds.
“The costs of doing forward deliveries are much lower than they used to be,” Fabian said. “Five or 10 years ago, they were more expensive, because there was an opportunity cost for the lender, there was a liquidity issue, and it was more difficult to predict if the forward delivery was going to happen.”
With the supply of tax-exempt debt not matching the demand for funds who want to hold a certain percentage of tax exempt debt, particularly with a significant amount of tax exempt debt refunded into taxables, investors are more willing to take that risk, Fabian said.
The reason he was skeptical of forward deliveries prior to the tax bill is it wasn’t always clear why issuers were using the tool, he said.
“In 2019, everyone knows why it is happening, and the likelihood of completion is extremely high, so that helps lenders overlook the risk,” he said.
And expectations are that yields will either be the same or lower when the transaction is executed, he said.
“Back in the day, you would do a forward delivery and worry yields might be 20 to 30 basis points higher,” he said. “But now the yields are so low, or stable, that the risk of receiving a below market instrument is unlikely. So, it works for both lenders and borrowers in the current context.”